9. Managing financial risk: interest rate and other risks

Question 1

derivative

Answer 1

a financial instrument whose value derives from an underlying financial item

Question 2

futures contract

Answer 2

standardised exchange-trade contract to buy or sell a specific amount of a notional underlying financial item on a certain date
they are bought and sold on specialist futures exchanges.

Question 3

option

Answer 3

gives its the holder the right, but not the obligation, to buy or sell an item on or before a future date, at a fixed price

Question 4

call option

Answer 4

an investor is entitled to buy the shares at the exercise price

Question 5

put option

Answer 5

an investor has the right to sell the shares at the exercise price within the specified period

Question 6

in the money

Answer 6

if exercised today, a profit would be made

Question 7

out-of-the-money

Answer 7

if exercised today, a loss would be made

Question 8

forward rate agreements

Answer 8

a contract which fixes the rate of interest on a deposit or borrowing with a term that starts in the future and lasts for several months.

Question 9

what would borrowers do?

Answer 9

1. sell a future
2. close out by buying future
3. borrowing on spot market

Question 10

forward exchange contracts

Answer 10

fix an exchange rate for a currency transaction for settlement at a future date

Question 11

forwards contract

Answer 11

a binding agreement to buy or sell an item for settlement at a future date, at a price agreed today. they can be tailored.

Question 12

how do options help hedge risk?

Answer 12

the option will remove the downside risk but leave the upside potential

Question 13

what are the time value of options affected by?

Answer 13

• time period to expiry of the options
• volatility of the market price of the underlying item
• general level of interest rates